Dirk Ehnts on the austerity fallacy

Historical evidence says that austerity doesn’t work, and to my knowledge there is no theory that supports it either. You can, of course, use neo-classical theory, but that is about flows, not stocks. You simply cannot jump to the conclusion that if you stop a flow (government expenditure) the stock (government debt) will change in the very same direction by the very same amount. For a single household, that may work: I save €100 a month more in order to repay my debt of €1,000, and after 10 months it is all over. However, if all households do it at the same time, then the increase in savings will cause a significant contraction in demand. Hence, firms will not be able to sell and not hire or fire workers. That will make the demand problem worse, since now these newly unemployed consume even less. The government income (taxes) will sink and expenditures will rise (unemployment insurance). There is no one-to-one relationship between the flow and the change in the stock!

The neo-classical theory is a strict flow theory and cannot deal with levels debt. In neo-classical theory, households (entrepreneurs) can only borrow from other households, so that aggregate household debt is zero and non-relevant. However, that is not what reality looks like. Households as an aggregate are indebted, and very much so. Also, some households might face bankruptcy problems. Using neo-classical theory in a situation where debt levels play a major role will lead to wrong policy prescriptions, like austerity. It is the same with some policy prescriptions of Keynesian theory in a situation of full employment, where debt levels might not be binding and a liquidity trap is nowhere in sight. When ideology rules, economies break.

Read it at Econoblog101
Boomtje Boomtje, Bustje BustjeDirk Ehnts | research assistant at the chair for international economic relations at University of Oldenburg, Germany